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Commodities cycle to front of the pack

Retail investors are being warned about having too much exposure to the long bull run that the commodities market could be about to enter.

Despite confident predictions that the price of commodities is likely to enter a 10-year upturn, IFAs and product providers are wary of unsophisticated investors putting cash into commodity stocks.

Chelsea Financial Services managing director Darius McDermott says that the volatility of commodities means they should only be used cautiously as part of a balanced portfolio. He believes that only clients who are prepared to take on risk should be recommended commodities stocks.

Research from fund managers used to develop a structured commodities product at Dawnay Day Quantum shows that the peaks and troughs of commodity prices tend to go in a 20-year cycle. There have only been three peaks since the 1920s, with the market taking a slight upturn in the last six months following a sustained period of price falls.

There is a robust case among analysts for a bull run in commodities that suggests prices that have fallen since the late 1970s have reached their floor.

One of the major arguments is that emerging markets such as India and China which need natural resources to support their economic growth are still not consuming as much oil per capita as the UK or the US. China consumes 1.5 barrels per capita per year, India one barrel, UK 10.4 and US 26.

On the supply side, excesses in cap-acity have been balanced out by surges in demand. Expenditure and refining has largely decreased and so it could take time before supply is stimulated enough to keep a cap on the price.

Commodity prices depend, broadly speaking, on basic supply and demand but this does not make them predictable enough to be good for cautious investors.

McDermott says: “They are definitely something to have as a component in a balanced portfolio and only really something for the more risky investor.

“The case for investing in commodities is a strong one, and could well offer good absolute returns. But with anything that could provide good returns there is a trade off for risk and volatility.”

Renewed interest in commodities began earlier in the year when Credit Suisse Asset Management announced the launch of a passively managed commodity fund. The commodity fund plus, which is available in Swiss francs, euros and dollars, aimed to replicate the performance of the Goldman Sachs commodity index. The portfolio structure meant that the fund had a low level of correlation with bonds and equities.

In July, Transact sealed a deal with commodities specialist Global Advisors in a deal that provided consumers with direct access to stocks.

The deal meant that IFAs could consolidate their clients’ investments into one account before placing it within the Global Advisors’ energy and metals fund. Global Advisors believed that direct investment into commodities was preferable to investing in commodity equity because the fund could take short positions whereas long-only funds investing in commodity companies would be hit by geared losses if commodity prices fell.

Its fund invested in cleared products, such as crude oil, heating oil, natural gas, nickel, copper, zinc, gold, silver and platinum.

The Dawnay Day Quantum fund invests equally in crude oil, heating oil, natural gas, aluminium, copper, nickel and platinum.

The danger of this, as McDermott points out, is that there is no scope to change the asset allocation if one of the component commodities is underperforming. However, on the plus side, the fund is guaranteed to return the investment after the six years. As a result, he has been recommending it to clients.

DDQ chief executive Mark Mathias thinks that commodities will be a good mid to long-term investment but he acknowledges that the sector is only really suitable for more sophisticated investors.

Mathias says: “We think that about five years is a minimum amount of time that you should stick with this investment that will help to iron out any short-term volatility. There are risks, it is inevitable for commodities, but this is a section of the market that has been overlooked by retail investors for far too long. By having direct access to commodities, you are able to take out any of the profit that you might lose when you invest in a commodity equity.”

Merrill Lynch Investment Managers natural resources team fund manager Evy Hambro believes that recent price volatility in the metals and mining sector have created an opportunity for retail investors. She thinks that record results from mining companies in the first half of this year will be bettered again in the second half of the year.

She says: “In contrast to prior commodity cycles, the management of the mining industry today seems determined to ensure that shareholders are well rewarded, overwhelming evidence is coming from the recent upsurge in share buybacks and dividend increases. In our opinion this bodes well for returns in 2005.

“Investors who believe, as we do, in the long-term positive outlook should look through the short term shifts in sentiment and take advantage of share price weakness to build positions.”

Understandably, commodities fund managers are keen for the commodities not to be seen as niche products. With traditional equity markets going sideways and absolute returns hard to come by, it seems inevitable that asset houses will look to chase returns in more volatile sections of the economy.


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